The End of the World as We Know It

I will begin this preamble to the subject systemic risk with two quotes from Warren Buffett (by quoting him I do not mean to imply his support in these efforts of mine):

  • Of excess leverage in the system, Mr. Buffett has said, “No one knows who’s been swimming naked until the tide goes out.”
  • Mr. Buffett calls derivatives, “financial weapons of mass destruction.”

I would like to explore the meaning of this in the context of unsettled trades in our nation’s settlement system.

Mark Twain said, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.”

Consider this scenario:

  • I loan you an umbrella.
  • You use that umbrella as collateral to borrow 5 more from someone else.
  • You take the 6 umbrellas and loan them out to your 6 brothers.
  • Each of your six brothers now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more. Each brother now has 6 umbrellas, and loans them out to 6 of his friends.
  • Each of those (6 brothers) X (6 friends each) = 36 friends now has one umbrella. Each uses that umbrella as collateral with which to borrow 5 more.
  • There are now 6 X 6 X 6 = 216 umbrellas in all.

It starts to rain.

  • I go to you and say, “I need back that umbrella I loaned you.”
  • You say, “But that was collateral for the 5 I borrowed! If I have to return your umbrella, I’ll also have to return the other 5 I borrowed using your umbrella as collateral.”
  • So you go to your six brothers and say, “I need those six umbrellas back!”
  • Each brother says, “But I used that umbrella as collateral for 5 more!” So they go out to get each of their six umbrellas back by going to their 36 friends and saying, “We need our umbrellas back!”

And so on and so forth. It is easy to see how this situation, where balancing upon one umbrella were 216 borrowed and reborrowed umbrellas, could unravel in a chain reaction of “unborrowing” and returning of umbrellas.

Remove “umbrellas” in the above example and replace it with “dollars,” and you get a good image of excess leverage in our financial markets, and one of systemic failure as well.

How could the government stop this collapse? In the umbrella example, the government would take truckloads of umbrellas and inject them into the umbrella market (perhaps by loaning them out at low rates) so as to slow down and even stall that chain reaction. In the example of our financial system, the government would do it by taking truckloads of dollars and injecting them into the capital market.

This is exactly what the government has been doing for over a year. The broadest measure of the money supply is called, “M3.” The government reported the rate of change in M3 since 1959. After reporting M3 for 47 years, in March 2006 the government stopped disclosing M3. From other numbers that are disclosed by the Federal Reserve, however, it is possible to back into M3. An economist named John Williams does just that on the Shadow Government Statistics website. According to Mr. Williams’ calculations, the rate of expansion in M3 has reached 16.7% – higher than at any time since they started reporting it (the last time it reached 16%, Nixon reacted by instituting wage and price controls).

That is problematic because (very roughly speaking) the growth in money supply will equal inflation plus growth in US productivity (along with other factors like velocity and number of transactions: that is why I say “roughly). According to the Fed, productivity is growing at just under 3%. If money supply growth stays gunned at 16%, underlying inflation will heat up over 10%, at which point the dollar will crack some more, at which point interest rates will be hiked into the high teens in order to tempt foreigners to continue loaning us money to subsidize our fiscal and current account deficits, at which point we will be thrust into an inflationary recession that makes the early 1970’s look like a Sunday picnic.

That is to say, massive amounts of liquidity are being injected into the US financial markets to keep it from imploding. This will lead to inflation (“Inflation is always and everywhere a monetary phenomenon,” wrote Milton Friedman and Anna Schwartz) then a recession.

Or not, if, as some believe, M3 is too volatile to worry about.

The “rain cloud” which was the proximate cause of this situation was the home mortgage crisis that began to be exposed in the summer of 2007. People bought homes with borrowed money for which they signed IOU’s (“mortgages”). Those IOUs were aggregated and resold, chopped up, packaged and resold again to firms which borrowed even more on top of them. Unfortunately, since everyone in the chain made money from fees charged for that aggregation, chopping and packaging, they had incentives not to notice that many of the folks underneath it all were signing IOU’s they would not be able to repay. Once they stopped paying their mortgages (i.e., once those “umbrellas” started to be recalled), the system started to collapse on itself. A coordinated effort by the largest central banks in the world injected money into the financial markets to stop a runaway implosion such as that described in the umbrellas example above.

There are numerous articles out there explaining the mortgage crisis in far greater detail than the above. I present this explanation for three reasons only.

  • The first is to provide the lay reader with the mental imagery by which to conceive of a systemic collapse.
  • The second is so that I could point out that the mortgage crisis was the rain cloud that triggered the current crisis, but it may not be the only rain cloud. Lots of storms have more than one rain cloud.
  • Third, the rain cloud is not the same thing as the underlying situation. It is merely the trigger which has caused an unhealthy underlying situation to manifest. It is important to understand not just the trigger but also that underlying situation: tremendous amounts of systemic leverage are, in the end, a giant confidence game (in the most literal sense), and if that confidence is disrupted the system can implode. What disrupts that confidence may be nothing more than a sudden, broad realization that more leverage has accumulated than has been generally understood, perhaps by accumulating in such a way that no one recognized it for what it is. I will argue in future posts that this is precisely what unsettled trades in our stock settlement system create.

Again, that third point is key: recognize that the mortgage crisis, while real, is a trigger but not the underlying situation. The dancer is different than the dance.

I would like to switch metaphors now, to discuss derivatives.

I ask you to imagine a special casino. On the ground floor, it looks like a normal casino. There are 100 people standing around playing craps, roulette, and blackjack. They each brought $10,000 so there is $1 million of betting on the first floor.

On the second floor, however, there is another casino. In that casino, people are watching television screens showing people gambling on the first floor. In the second floor casino, people bet each other on who they think is going to win and lose on the first floor. All the really big players are in that second floor casino, and they are betting hundreds of millions of dollars of action on various people in that first floor casino. Their outcomes are “derivative” of the outcomes on the first floor. A roll of the dice on the first floor that loses someone $100 may create tens of thousands of dollars of losses on the second floor (and if there is a third floor where people are placing even bigger bets on the outcomes on the second floor….)

I will argue that unsettled trades in the financial system bear the characteristics of such derivatives. However, they present a special kind of derivative. If you and I walk into the first floor casino and bet on whether the next roll of the dice is a 7 or not, no amount of betting on our part can affect the underlying event. Similarly, the underlying event will not be affect by any amount of betting by the people above us on the second floor (or by betting on them by people on the third floor).

Unsettled stock trades, however, can affect the underlying events upon which they are a bet. In fact, unsettled trades resulting from “the option market maker exception” are often the by-product of deliberate efforts to affect those underlying events. When an underlying event that someone deliberately affects is a stock price movement, it used to be called, “manipulation” (and was also called “illegal” until Wall Street captured the SEC, at which time it became known as, “a hedge fund business model”).

Because unsettled trades have this property of affecting the underlying events upon which they are a bet, they are derivative contracts with an especially nasty twist.

I tell you, that guy Buffett will go places.

PS Again, because I do not wish to imply endorsement of my views, I am going to give one additional quote, without comment. In May, 2007 Messieurs Buffett and Munger were asked to comment on the issues I am raising here in Deep Capture. Mr. Munger’s response was as follows (page 6): “Those delays in delivering sometimes reflect tremendous slop in the clearance process. It is not good for a civilization to have huge slop. Sort of like how it isn’t good to have a lot of slop in nuclear power plants.”

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